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Negotiating an Oil & Gas Lease

Five Key Issues to Consider

Landscapes Summer 2012

Oil pumps at sunset

Landowners may dream of oil and gas production on their property, especially if they own the minerals. But before exploration or production can begin, the landowner and the oil and gas company involved must sign a document known as an oil and gas lease.

It is critical that the landowner understands and negotiates the proposal before signing. This may be difficult, however, if the land man — the person representing the oil company — is offering a large incentive known as a bonus payment: The sooner you sign, the sooner you get paid.

Do not be rushed into signing a document that may not represent your best interests. Instead, study the contract, consult with a legal expert if necessary and know what you are signing. Practically everything is negotiable if you know how and what to negotiate.

Following are five of the most critical issues to consider when negotiating an oil and gas lease.

Bonus Payment

The first issue you, the landowner, should explore is how the bonus payment is being tendered. It may be offered in the form of a check or a bank draft. If possible, avoid drafts, which generally are funded 30 banking days after they are deposited. Request a check or possibly a cashier’s check to ensure prompt payment without problems.

Limitations on Production

Limit the lease to the production of oil, gas and associated hydrocarbons. Eliminate any references to “all other minerals” or “other minerals.” In Texas, this language extends production and possibly mining to such things as uranium. In other states, the interpretation of the language may vary.

Do not be rushed into signing a document that may not represent your best interests.

Acreage Per Well

Address the number of acres one producing well holds. Although with most leases one well holds the entire leased premises, only a small portion may be dedicated to actual production. Limit the lease to producing acres (sometimes referred to as the acreage placed in a production unit) at the end of the primary term or some later time if continuous drilling operations are permitted and pursued. If your land is located in a state that does not require the creation of production units, state explicitly how many acres one producing well holds. A good number is 40 acres for a vertical oil well. Horizontal gas wells require more land.

Depth Limitation

Limit the depth covered by the lease. Unfortunately, most leases provide that one producing well holds the entire leased acreage to the center of the Earth. If the property contains several producing formations at different depths, the oil company does not need to get a new lease to drill to and produce from a lower formation, as long as the lease has not terminated. Some leases executed in the 1930s are still producing, but from lower depths.

To avoid this scenario, negotiate a depth clause, sometimes called a horizontal severance. If the oil company is targeting a specific formation, such as the Barnett Shale or Eagle Ford Shale, limit the lease to 100 feet above and below the stratigraphic equivalent of that formation. If this is not the case, limit the lease to 100 feet below the stratigraphic equivalent of the deepest producing formation at the end of the primary term or at some other specified time.

Cost-Free Royalty

If possible, make the royalty cost-free. Generally, royalty payments are free of all production costs involved in extracting oil or gas from the ground. After that, royalty owners share in all post-production costs to make the product marketable and to move it to the marketplace. The amount of the share (the deduction) is based on the size of the royalty. Post-production costs may run as high as 2 percent of a 20 percent royalty, meaning the royalty owner nets out at 18 percent.

Finally, do not get in a hurry to sign the proposed lease. There is a saying in the oil and gas industry that only the needy and the greedy take the first offer.

For more information, see “Hints on Negotiating an Oil and Gas Lease” on the Texas A&M University Real Estate Center’s website.

– Judon Fambrough

Judon Fambrough is a senior lecturer in real estate law at the Real Estate Center in the Texas A&M University Mays Business School. As an attorney, he specializes in property rights, including oil and gas, wind power, hunting leases and landowner liability.

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